Removing the Mystery from … Prepayment Penalties

What is a Prepayment Penalty?

Simply put, a prepayment penalty is a disincentive designed to keep you from paying off your loan too quickly. This penalty can be an expensive price to pay, often six months interest, for chucking your old loan in favor of a refinance at a lower rate or even a new purchase. The penalty is most commonly found with subprime loans (loans for those with less than optimal credit scores). But a low credit score is not the only recipe for a prepayment penalty. Many other so-called “A paper” loan products may carry the penalty as well, including non-conforming products like payment option ARMs.

Prepayment penalties generally fall into one of two categories – “soft” and “hard”. A “hard” prepayment penalty is imposed for any full payoff of your old loan – whether as a result of a refinance or the sale of your property. The “soft” variety is slightly more forgiving, as the penalty is incurred only if you refinance. In either case, you may be subject to the penalty simply by prepaying too much principal – even if you don’t kill off the loan entirely.

Prepayment penalties have different durations associated with them, but a typical timeframe is one to three years, after which time the penalty may go away. Most home loans do not have prepayment penalties – but it is important to understand how they work and if you have one on your loan.

Why do lenders impose them?

Most penalties exist because the type of loan requires it. For instance, subprime loans often carry a much higher rate than an ‘A’ paper loan because of the extra risk that the lender assumes. The lender knows that when your credit profile improves, you will attempt to refinance into a loan with more favorable terms as soon as possible and the old lender will lose revenue as a result of it. This is not necessarily a dirty tactic, but rather something that the lender must do to be profitable, and it is a constraint that you may have to face with certain types of loans.

Some prepayment penalties can be added by the lender, or even intentionally selected by the borrower because attaching a prepayment penalty may result in a slightly better rate. If you expect that you will keep your loan for longer than the penalty period (usually one to three years) you might choose to have a prepayment penalty if your loan has that option.

A good lender should tell you about any potential penalty and how it works, but beware of the lender who attaches a penalty onto your loan without your knowing it. This certainly isn’t typical, but it can happen to the unwary borrower. That’s why it is so important to find a reputable lender.

How do you know if you have one?

Your “Truth-in-Lending” statement, or “TIL” that you receive at closing should have a box checked in the lower half of the page that shows whether or not you have a prepayment penalty. You can also check your “Note” for the inclusion and details of any penalty. In most cases, you can prepay principal as much as you like as often as you like. But you should always double check or have your attorney review your TIL and Note for any new mortgage as well as on any old mortgage that you are getting ready to pay off so that you are not subject to any unwelcome surprises.

If you find that you are subject to a prepayment penalty, then it’s time to consider whether paying off your loan makes sense. You may find that the benefits outweigh the disadvantages of paying the penalty. Also, you should check with your tax advisor to determine if your penalty is tax deductible.

At Apple Street Mortgage, we never include a prepayment penalty unless it is required by the type of loan and, in that case, it will be carefully explained to you. We also double check your “TIL” at closing to make certain that a prepayment penalty isn’t inadvertently attached. And we’ll check the terms of your old loan for you to make sure that you don’t have a penalty on that loan. If you do, we’ll advise you on how best to proceed.